Friday, March 7, 2014

The Conundrum of Investing in the Eurozone

I was asked yesterday whether I thought macro or micro factors were more important for investing. I probably didn't do a very good job answering the question, but I think there's a great danger in trying to create a dichotomy between the two. Legendary fund manager Peter Lynch famously boasted, "I've always said if you spend 13 minutes a year on economics, you've wasted 10 minutes." I agree you can get too caught up thinking about the big picture, and fail to recognize when investor expectations are too negative. But I also think you're doing yourself (and your investors) a grave disservice if you aren't thinking about how individual companies will perform in various macro scenarios. And specifically with monetary policy, it's easy for equity investors to ignore until it goes wrong, as it did in 2008. (I think David Beckworth has made this point in a blog post, but I can't find the exact post to cite him.) If you think low economic growth is likely to persist, or that full-blown crisis may reignite, that had better darn well be in your cash flow projections or your discount rate.It won't come as surprise to many of you that I am fairly negative on the prospects of the Eurozone. It's a far from optimal currency area, with divergent economic levels and models, greatly hindered by a central bank that appears to approach its (dangerous) single price mandate with asymmetry. Eurozone NGDP is far from its pre-crisis trend, leading to severe unemployment and dangerously low inflation.Still, I'm concerned that I'm being too unimaginative about how a recovery could take place (this blog is called The Insecurity Analyst, after all). We're all susceptible to confirmation bias, and it's almost harder to escape today, since many of us create our own information bubbles by selecting people to follow on blogs and Twitter. So let's consider a bullish case for the Eurozone as an investment.1) Savvy investors are returning to the area. George Soros said his fund is investing in European banks, while he and Paulson are also investing in Spanish property. Of course, we're missing what price they're investing at. Obviously, you can make money if you think an investment will only return 50 cents on the dollar, but is trading at 20 cents. Expectations matter! (And as another aside, I recognize that being negative on the prospects on the Eurozone can be expressed several ways - most likely, shorting the currency, peripheral debt or equities. Even if the Eurozone does badly, these aren't all equally sensible trades. You'd have done well shorting Japanese equities but gotten murdered shorting the yen - see below.) 2) NGDP isn't returning to pre-crisis trend, but improvements in other indicators signal a recovery and passive easing of monetary policy. Since the dark days of 2012, the CAC 40 is up 50%, the DAX and MIB about 60% and the IBEX 35 almost 70%. Those are pretty stunning returns. Meanwhile, the yields and spreads on peripheral debt have fallen dramatically. I sat in on a presentation by Nomura's peripheral debt desk, and their strategist laid out some fairly comprehensive statistics on how Portugal can continue to muddle through (not reducing their overall debt load, mind you, but not collapsing into crisis again either).3) Some investors continue to underestimate the political will to keep the Eurozone together. Policy makers will react slowly to crises, but when their backs are against the walls, they'll do the right thing.I don't want to be too pig-headed about this. As I conceded earlier, valuations matter. Soros, among others, says he thinks economic conditions are calming down but that Europe could face a long period of stagnation like Japan. But I'm still skeptical for two reasons. First, look at the chart of the Nikkei 225. You would have struggled to make money in Japanese equities, unless you were a hell of a trader. You could have sounded the all-clear at many points between 1990 and 2009, and then proceeded to be totally wrong. Tight monetary policy is not good for equities. Second, Japan is famous for its social cohesion, which allowed society to continue functioning despite dire economic performance. Similarly, Sweden can survive with its overly tight monetary policy today. Do you think the Eurozone will survive another 10, or even 5 years of similar economic performance? I just find that hard to believe, and have to think that, once again, we'll see the "political news slipping into the financial section."But I'd like to be convinced otherwise. So go for it!